Mortgage lending in the current low-interest rate environment made 2003 a banner year for the U.S. banking industry. Banks earned a record $120 billion last year. However, the industry continues to become more concentrated with fewer small banks. Smaller banks are less able to garner cheaper funds for lending from wholesale markets and are less able to mitigate their credit and interest rate risks through participation in securitization and syndication markets. Smaller banks are more vulnerable to the increased indebtedness of borrowers and anticipated rising interest rates. The three largest banking institutions have assets in the range of one trillion dollars each. Their combined assets represent 30% of FDIC-insured banks. The next four banks hold another 13% of these assets, and the top 25 banks hold more than 50% of the assets of FDIC-insured banks. As a result of bank consolidations, at the end of 2003 there were 118 fewer commercial banks, and 55 fewer savings institutions, than there were at the end of 2002. The Senate Committee on Banking, Housing, and Urban Affairs held a hearing on the condition of the banking industry on April 20, 2004, where most of the issues in this report were discussed.

Despite the overall growth in deposits in the banking system, deposits at smaller banks have begun to decline as deposits at the larger banks continue to grow. Deposits at commercial banks grew at 7.2% and 5.0% at saving institutions between 2002 and 2003. However, in the same period for all FDIC-insured institutions with less than $100 million in assets, deposits declined by 5.0% while deposits grew 10.0% at institutions with assets greater than $10 billion.

The high liquidity and profits in the banking system could be reduced rapidly if relative yields on alterative investments increase sharply due to higher interest rates. In the recession of 2001, smaller banks had not heavily lent to nonfinancial, high-tech companies, which became financially troubled during the recession. Large banks were doing most of that lending, but they were also better prepared for the recession because they had diversified their sources of funding. Despite their preparation, the noncurrent asset ratio (loans at least 90 days past due divided by total assets) for FDIC-insured banks went up to 1.00% for commercial banks with assets greater than $10 billion. Since then, these same institutions' noncurrent asset ratio declined to 0.80%. Smaller commercial banks (less than $100 million in assets) have seen a slight increase in noncurrent assets since the 2001 recession. The ratio went from 0.81% in 2001 to 0.83% in 2003. This slight increase might reflect smaller commercial banks' increased exposure to interest rate risk.

Larger banks are likely to become even more efficient users of regulatory capital under Basel II and thereby better able to expand lending with the planned implementation of Basel II capital rules. Smaller banks would continue to operate under the more burdensome regulatory capital standard, Basel I.

This report will be updated as legislative and financial developments warrant.